Diversification is an important part of investment success, and one way to achieve it is by buying Exchange Traded Funds, or ETFs. These funds can be an extremely useful and low-cost way to gain exposure to all sorts of markets and investment assets, but they also vary in complexity and risk.
Here are answers to some of the most frequently asked questions about these funds.
What is an ETF?
An ETF is an individual stock that is bought and sold on a stock exchange. However, the stock itself tracks the performance of hundreds, or sometimes thousands of individual companies or commodities, so it acts like a tracker fund.
Some of the good things about this are the fact that, unlike other funds which are priced once a day, the price of an ETF moves like other share prices, so investors know what price they are buying at. These funds can also be very cheap, as they lack an active manager in most cases.
One of the main reasons to use ETFs is to gain exposure to markets that are otherwise hard to access as an individual investor, such as infrastructure, the oil price or an overseas stock exchange.
What can an ETF track?
It is possible to find ETFs that track almost any index you can think of, from the FTSE 100 to companies involved in blockchain technology. ETFs can track the price of commodities such as gold, copper or the price of pork, too.
Some ETFs go even further than simply tracking an index - they can apply a ‘tilt’ algorithm that predisposes them to weight certain types of company more highly within their portfolio - for example they might tilt a simple FTSE 100 tracker towards companies that have paid continuous dividends for a period of time.
Some ETFs ‘track’ a theme - for example businesses operating in Artificial Intelligence or adhering to certain ESG (Environmental, Social, and Corporate Governance) principles.
This variation means that ETFs can be either very simple or very complex, so it is important to understand exactly how an individual fund works before investing.
How risky are ETFs?
There are many different types of ETF, and some are more risky than others. For example, an ETF tracking a bond market is likely to be less volatile than one tracking the performance of the FTSE 100. Those tracking more esoteric markets or commodities are more volatile still.
There may be an extra level of risk involved with ETFs, however, depending on how they are structured. Some ETFs are physical - they hold the actual stocks or commodities that they are tracking, allowing them to replicate performance exactly. Others are what are known as ‘synthetic’ ETFs, which means they replicate the performance of an index using a series of complex financial instruments.
Synthetic ETFs make it easier to track hard-to-reach markets, or those where it is not easy to buy and sell an asset. They may also be cheaper in some cases. However, this does at a level of what is known as ‘counterparty risk’ to some products, where investors suffer if the business on the other end of a financial instrument in the ETF is unable to pay its way.
Are ETFs tax efficient?
In some countries, including the US, ETFs are a more tax efficient way to invest, but in the UK the taxation works in much the same way as other funds. It is possible to hold them in either an ISA or a pension for maximum tax efficiency though, and there is no stamp duty when you buy or sell an ETF.
Summarising the key points characterising different types of ETFs
In summary, some of the most important things characterising an ETF are:
- What index is it tracking and in what currency (as there may be added currency risk if you are tracking something overseas)
- Is the ETF physical or synthetic?
- What are the charges?
Used well, ETFs can be an important part of any successful portfolio, as long as the appropriate research is done in advance.